You can’t blame homebuyers from getting sticker shock at the recent jump in mortgage rates. Since the close of 2021, the rate on the classic 30-year home loan ramped at a speed virtually never before seen in a four-month span, spiking from 3.1% to 5.25% as of April 25. But potential buyers should consider not just the new, raw number––the highest in twelve years––but what they’ll be paying per month versus the trend in inflation. Put simply, periods of fast-rising prices are good for homeowners who are making the usual fixed-monthly payments, especially when their mortgage rates are lot lower than the pace of the Consumer Price Index. In that scenario, you’ll be covering the same monthly nut with the inflated dollars that should be fattening your paycheck. “Sophisticated buyers won’t be much worried about mortgage rates just over 5%, and much lower than that after-tax, when inflation’s much higher, and homes are still appreciating so fast, in part because so few are for sale,” says Ed Pinto, director of the American Enterprise Institute’s Housing Center.
Indeed, we’ve just witnessed a sudden, a giant chasm open between mortgage rates and inflation that’s put the distance and direction separating the two in virtually uncharted territory. Mortgage rates that exceed increases in what families pay for groceries, shelter and transportation have been a fact of life for decades. From the beginning of 1990 to the end of last year, the home loan rate has exceeded inflation by a median of 3.6 points. As recently as December of 2020, new buyers were booking mortgages at 2.7%, while the CPI loped at just 1.3%, putting the “real” or inflation-adjusted home loan rate at 1.4%. But suddenly, those numbers have reversed almost overnight. While mortgage rates have nearly doubled since the start of 2021, inflation’s waxed far faster, exploding six-to-seven fold. Beginning in January, the real mortgage number went negative for the first time since the 1970s, and by April, the CPI reading hit 8.6%, exceeding the average home loan number of just under 5% by 4.4 points. We’re now in a virtually-unknown era of not just negative, but severely negative real rates on mortgages, measured against current inflation.
Why high inflation blunts mortgage costs
Despite their rapid recent rise, today’s mortgage rates remain a green light for homebuyers. At just over 5%, they’re still low by historical standards, sitting well below the average of over 7% in the 1990s, and above 6% in the aughts, and the median of 6% since 1990. Their newfound status trailing the rise in the cost of living also helps make today’s home loans a winner. It’s extremely likely that inflation will remain higher, maybe much higher, than the 30-year mortgage rate for a considerable period. Steve Hanke, the noted monetarist and Johns Hopkins professor of applied economics, predicts that the CPI will wax at over 6% this year, and stay on trajectory for all of 2023 and possibly into 2024. Families’ incomes are strongly linked to inflation, and usually rise a couple of points faster. So the share of a household’s salaries going to their monthly payment will actually decline faster in periods of fast-rising prices because mom and dad’s combined paychecks are increasing much more rapidly than usual. That just keeps them a little better for meeting most living expenses. But it’s a boon for their costs as homeowners, since they’re still writing the same, fixed monthly check.
Or look at the inflation effect another way: The faster overall prices are rising, the lower your inflation-adjusted mortgage payments will be in the future.
Let’s examine an example. Take a family making $90,000 a year, or around $70,000 after tax. They got a 3.7%, pre-COVID home loan in late 2019. It’s really costing them 2.9% after deducting interest on their tax returns. The annual cash outlay on their $700,000 home loan is $20,300 (2.9% of $700,000), or $1,700 per month. At the close of 2019, the CPI was increasing at an annual rate of about 2%. Say their incomes are beating inflation by 2 points, so their paychecks swell each year by 4%. If the U.S. had stayed on its former 2% trajectory for consumer prices, their inflation-adjusted mortgage payment three years hence would have been $19,130 year, or almost $1,600 a month. That’s the beauty of owning a house: Your pay rises while the nut says the same.
How about another family looking to buy now? Is the vault in rates a killer? Hardly. At 5.25%, folks buying today would be spending 4.1% after tax. That’s $28,700 on that same $700,000 home loan, or $2,400 a month. The $800 or 50% increase over the family with the 3.7% loan sounds huge. But here’s where inflation helps out. Let’s assume we get average 6% price increases for the next three years––keep in mind we’re at 7.8% so far in 2022 with no relief in sight. By early 2025, the inflation-adjusted payment would be $24,100, or $2,000 per month. Big inflation would shrink the difference between the cost on a 3.7% and today’s 5.25% home loan by half. Sure, the “real” amount would increase from $1,600 to $2,000 a month. But the $2,000 inflation-adjusted outlay would remain relatively low as a share of their household income.
What higher rates mean for housing prices
Of course, we don’t know if inflation will rage at 6% into 2025. The bond market’s expecting a sharp slowdown later this year and into 2023. As Hanke points out, however, the Fed-driven, gigantic growth in the money supply used to “monetize” the trillions in COVID relief spending could well saddle the U.S. with number at or close to that level. It is likely that inflation goes back to the 2.5% to 3% range, however, in a few years. At that point, the “real” mortgage rate will once again be positive and homeowners won’t be getting the same boost from inflation. But most families don’t own a house for the 30 year term of their home loan, or even close to it. A more normal period before they switch to another abode is 7 or 8 years. Paying a “negative” mortgage rate lower than the clip at which your cost of living rises for one-third to half the time you hold the home loan is a major plus.
For Pinto, it will take much higher rates to slow today’s gangbuster gains. “Nationwide, houses should appreciate the mid-teens this year, and around 11% in 2023,” he predicts. Pinto notes that the volume of sales has declined from the incredible rates of early 2021, but remain above healthy pre-COVID levels, and attributes most of the fall to historically low stocks that are severely limiting buyers’ choices. He adds that the prospects that house prices will keep chugging, so it’s still a good time to board the train, are a “green flag” for potential buyers. The fast rise in rents, now advancing at an annual rate of 17%, is also luring investors to increase their portfolios in the thriving single family home rental market.
“I see all green flags with rates at between 5% to 6%,” says Pinto. He believes that it will take another jump to the 6% to 7% range to greatly slow appreciation. “Then, you’d see a significant drop in demand and increase in inventories,” he says. But prices wouldn’t go negative; they’d simply reset by rising in the mid-single digits. For Pinto, it would take a 10-year Treasury rate of 4.5% to 5.0% to get the 30-year number to the 6.5% that would slow the gains to one-third of their current pace. That’s as much as 75% higher than were the long bond stands today.
Mortgages aren’t the fabulous bargain of a year ago, but they remain attractive compared with most periods, and especially in this time of rampant inflation. It’s good for folks who own houses, it’s even good for people looking to buy now and can afford a home that’s 30% pricier than pre-pandemic. The losers are the lower income families for whom the backlash from easy money is killing the American dream.
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